From the moment decision-makers several months ago identified resolving excess capacity as one of the key battles in supply-side reform, to last week when President Xi Jinping and Premier Li Keqiang both emphasized during their field inspections the need to accelerate the elimination of excess capacity in traditional industries, it seems we can now confidently conclude that decision-makers’ determination to tackle excess capacity has reached a new high. As the most critical policy focus for the future, investment opportunities arising from resolving excess capacity within the framework of supply-side reform are likely to persist throughout the entire year.

To this end, we have revisited the deeper implications of resolving excess capacity and, based on the various approaches to capacity reduction, identified the different investment opportunities that warrant attention throughout this process. Meanwhile, Anxin Strategy has joined forces with industry teams from Anxin Chemical, Anxin Nonferrous Metals, and Anxin Steel to analyze the investment logic underlying each specific sub-sector suffering from overcapacity.

Report Summary:

Our understanding of “resolving excess capacity” in supply-side reform should be elevated to a higher level and expanded to a broader scope. Upon re-examining the deeper implications of resolving excess capacity, we believe that capacity reduction must be approached from both direct and indirect angles in order to enhance the likelihood of success:

1. Direct method: That is, the goal of capacity reduction is achieved by various direct methods of reducing supply, which can be broadly categorized into two main models. First is... Passive mode, This includes forced production cuts triggered by consecutive losses and broken funding chains (leading listed companies are more resilient than small and medium-sized enterprises), as well as the restructuring of state-owned enterprises in traditionally overcapacitized industries, which has been directed by regulators (though forcibly imposed changes may not yield desirable results, and stock prices indicate that investors do not fully endorse such moves). Secondly, ... Active mode, This includes leading companies in niche sectors proactively seeking capacity consolidation within their industries, as well as traditional-sector firms leveraging their ample cash reserves to actively shift toward upstream and downstream segments of their respective value chains.

2. Indirect method: In other words, by promoting strategies such as “mass innovation and mass entrepreneurship” and “Internet Plus,” we can create new business models and generate more job opportunities to help employees from traditional industries find new employment after capacity reductions. This approach is remarkably similar to the way China mitigated the massive unemployment caused by capacity cuts in the textile and light-industry sectors in the late 1990s following its accession to the WTO.

Supply-side reform will be the main policy theme for 2016, and among its key priorities is the resolution of excess capacity. We need not doubt the government’s determination to reduce overcapacity. Drawing on the experiences of the U.S., Japan, and China in the 1990s—when they undertook capacity reductions in the textile industry—we also have no reason to question the likelihood of success in this endeavor. What truly needs to be considered now is how to seize the corresponding investment opportunities in the A-share market during the process of capacity reduction. Over the past week, the market has been fraught with volatility and turmoil. Yet, traditional sectors plagued by overcapacity—such as steel and coal—have seen consecutive days of sharp price increases accompanied by rising trading volumes. Rather than hesitating about whether to chase this round of thematic opportunities, it would be wiser to start from the two key aspects of capacity reduction mentioned earlier and carefully examine how to position your investments over the coming year around this central policy theme.

1. Pulses of opportunity across the entire sector: Overall opportunities in sectors suffering from overcapacity—such as coal, steel, nonferrous metals, and chemicals—will continue to emerge in the form of pulses. To position oneself for these sector-specific opportunities, one must grasp the policy rhythm from top to bottom while closely monitoring price fluctuations from bottom to top.

2. Long-term opportunities in selectively chosen individual stocks: When selecting stocks related to supply-side reform that can support long-term strategic planning, two logical approaches can be followed: First, choose leading companies in niche industries that have the conditions for capacity consolidation; second, select companies in traditionally oversupplied industries that are actively transitioning toward upstream and downstream sectors.

The above is a series of analyses conducted from a macro perspective, focusing on “resolving excess capacity” itself as well as the related investment opportunities. However, for the major sub-sectors experiencing overcapacity, the underlying logic differs somewhat.

1. Chemical industry: Selection of industries and targets for supply-side reform: 1. The industry itself is already gradually recovering its supply-demand balance, and once the reform is implemented, it is expected to yield significant results; 2. The industry has high concentration and features leading enterprises with strong competitiveness (preferably state-owned enterprises); 3. The products have high price elasticity and are already showing signs of consolidation.

2. Colored: When selecting stocks based on earnings resilience and the potential for integration through mergers and acquisitions, aluminum is our top pick. On the one hand, aluminum is the most oversupplied commodity in the non-ferrous metals industry, subject to the strongest policy intervention and characterized by the weakest market-driven liquidation. On the other hand, persistently low aluminum prices have led to a gradual decline in new capacity year after year, and medium- to long-term price expectations have already begun to improve.

3. Steel: First, the steel trading sector—among the first to be hit by overcapacity—is now leading the industry’s transformation, and steel e-commerce has become a widely recognized consensus for industry development. Second, although the steel industry currently tends to adopt a cautious stance toward mergers and restructuring, given the overall industry development trends and the ongoing supply-side reforms, a new wave of mergers and restructuring is inevitable. The steel products segment is the primary battleground for capacity reduction within the industry and also the sub-sector with the highest expectations for industry consolidation.

Risk Alert: The substantive progress in resolving excess capacity has fallen short of expectations.

Report body:

1. Re-examine the deeper implications of resolving excess capacity.

Over the past seven to eight years, due to overcapacity in fixed-asset investment and a significant slowdown in its growth rate, the related industrial chains have experienced widespread overcapacity. Among these, industries such as steel, coal, nonferrous metals, building materials, and chemicals—particularly those in infrastructure and real estate—have been hit hardest.

Judging from the statements made by decision-makers over the past few months, we believe that our understanding of “resolving excess capacity” in supply-side reform should be elevated to a higher level and expanded to cover a broader scope. Upon re-examining the deeper implications of resolving excess capacity, we conclude that reducing capacity must be approached from both direct and indirect angles in order to enhance the likelihood of success.

1.1. The direct approach to resolving excess capacity

The so-called direct approach to resolving overcapacity involves directly reducing production capacity through various passive and active measures, thereby achieving the goal of phasing out excess capacity. Specifically, we further divide this direct approach to capacity reduction into two distinct types.

(1) First is passive mode:

The passive approach to capacity reduction is often a measure forced upon enterprises out of necessity, or imposed by the government through strong administrative directives and policy mandates. This includes situations where enterprises are compelled to shut down capacity due to sustained losses and broken capital chains, as well as the restructuring of state-owned enterprises in traditionally overcapacitized industries, as directed by the State-owned Assets Supervision and Administration Commission.

■ The first to be forced to shut down will be small and medium-sized enterprises; listed industry leaders, meanwhile, will benefit from the earnings flexibility brought about by capacity reductions and rising prices.

For local governments—especially those at the district and county levels, where the economic structure is relatively homogeneous—the traditional cyclical industries such as steel, coal, nonferrous metals, and chemicals, though already grappling with overcapacity, often remain among the most important sources of tax revenue for these localities. At the same time, these heavy-asset industries tend to be the largest employers in the region. Consequently, the process of resolving excess capacity through closures and bankruptcies is bound to be extremely painful.

On balance, we believe that the enterprises forced to shut down will primarily be small and medium-sized companies within the industry. On the one hand, SMEs themselves typically have weaker operational and financing capabilities, making them more vulnerable to cash-flow disruptions and likely to be the first to succumb during this harsh period of capacity reduction. On the other hand, compared with large state-owned enterprises, SMEs play a relatively limited role in supporting local finances and local employment; thus, during the forced shutdown process, the conflicts of interest among various parties remain within manageable bounds. Therefore, from this perspective, whether relying on their own strengths or on subsidies from groups and the government, leading listed companies are highly likely to survive the process of capacity reduction and reap the performance flexibility brought about by shrinking capacity and rising prices.

■ Top-level-directed restructuring of state-owned enterprises: A forcibly twisted melon won’t taste sweet—it may not be a method highly favored by the A-share market.

Previously, in our in-depth report on the restructuring of central state-owned enterprises, we predicted that among companies operating in industries suffering from overcapacity, only ultra-large enterprises would be able to navigate the process of capacity reduction by leveraging their advantages in scale, capital, and credit. Ultimately, this process of eliminating excess capacity would come to an end with the bankruptcy and closure of most small and medium-sized enterprises. After undergoing this rigorous cleansing, the ultra-large enterprises would emerge stronger than ever. Consequently, large central state-owned enterprises in these industries will adopt a strategy of mergers and reorganizations, joining forces to weather the winter together.

Since then, listed companies under corporate groups represented by China Minmetals Corporation, China Metallurgical Industry Planning and Engineering Corporation, Dongfeng Motor Group, China Ocean Shipping Company, and China Ocean Shipping (Group) Company have indeed experienced a significant rally, driven by expectations of mergers and restructuring. However, as various external factors continue to dampen risk appetite, the market has begun to raise increasingly diverse questions about the manner in which these state-owned enterprises are being restructured—ranging from concerns over the reshuffling of management teams following group reorganization, to issues related to improved coordination and efficiency, and even the contraction of production capacity. The performance of stock prices already reflects investors’ attitudes toward these developments.

(2) Next is the active mode:

Unlike passive capacity reduction, proactive capacity reduction is a process in which enterprises, relying on their own strengths and spontaneously, use various approaches to reduce excess capacity. This includes leading companies in specific sub-sectors actively seeking industry-wide capacity consolidation, as well as traditional-sector firms leveraging their ample cash reserves to proactively shift toward upstream and downstream segments of their respective value chains. From the perspective of the A-share market, companies that proactively reduce capacity through active measures may gain greater recognition from investors.

■ Among segmented industries, once the leading companies successfully consolidate, they will gain pricing power and enjoy earnings elasticity driven by rising prices.

The industry consolidation actively sought by the leading companies in the niche sectors we’re discussing here differs significantly in logic from the current mergers and restructuring of state-owned enterprises aimed at addressing overcapacity. The logic behind leading companies in niche industries seeking industry consolidation can be explained using game equilibrium theory.

Let’s assume that in a niche industry suffering from overcapacity, there is a leading firm, A, along with 10 medium-sized firms—B, C, D, and so on—and none of these 11 companies has any control over output or pricing. In such a scenario of overcapacity, prices keep falling and falling. However, from the perspective of the Nash equilibrium in game theory, for each individual company, the optimal strategy is to maintain its current production level rather than cut back. Otherwise, the first company to reduce production will inevitably suffer the greatest loss of market share. In other words, the individual rationality of the 11 companies collectively leads to irrational behavior across the entire niche industry—a situation that closely mirrors the current state of OPEC countries.

However, once the industry leader A completes the consolidation of about three out of the remaining ten companies, the entire industry landscape will change dramatically, and the Nash equilibrium will be disrupted. After the industry consolidation, Company A will significantly strengthen its position and market power, gaining control over pricing. As a result, it will be able to set the industry’s optimal output and price at levels approaching those of a monopoly, while the remaining companies will all adopt a follower strategy. As a result, while capacity in this sub-sector is brought under control, leading company A will also have substantial room for performance growth as prices rise.

■ For companies in industries suffering from overcapacity, undergoing a transformation often means entering entirely new fields, which requires extraordinary courage and strong financial resources.

Companies actively undergoing transformation in industries suffering from overcapacity are, in essence, also reducing the industry’s supply—a direct approach to resolving excess capacity. However, not every company can succeed, and not all forms of transformation can be smoothly completed.

On the one hand, the best approach for transformation is to extend upstream or downstream along the industrial chain, or to complement the company’s core business. This strategy significantly increases the likelihood of success—for example, steel companies transitioning into online steel trading platforms, or real estate firms shifting toward elderly-care real estate. The market has also rewarded these companies with higher valuation premiums.

On the other hand, companies undergoing transformation need to have sufficient boldness and courage to break free from the constraints of their original core businesses. At the same time, transformation requires substantial capital investment; companies with ample cash reserves are more likely to succeed.

1.2. Indirect Approaches to Resolving Excess Capacity

The so-called indirect approach to resolving overcapacity refers to a series of policies and measures adopted during the direct process of capacity reduction—measures designed to provide a safety net and hedge against downward pressures on the economy and employment. We believe this aspect is of strategic importance in the supply-side reform aimed at addressing overcapacity, yet it is also the part most likely to be overlooked by investors.

Last week, Premier Li Keqiang chaired a symposium in Taiyuan to address the resolution of overcapacity and the revitalization of the steel and coal industries. During the meeting, he emphasized that while adjusting and optimizing industrial structures, we must not focus solely on traditional industries; rather, we should place greater emphasis on developing new industries and new business models—new growth drivers—and build “dual engines.” This will create conditions for reducing surplus personnel in traditional industries and opening up new employment opportunities. By fostering innovation and boosting labor productivity, we can inject fresh vitality into these industries.

In the 1990s, the rapid expansion of credit lending led to severe overcapacity in light industries such as textiles, causing state-owned enterprises to suffer heavy losses. Consequently, toward the end of the 1990s, industries characterized by overcapacity—starting with textiles—began a difficult process of capacity reduction. During this period, workers’ wages declined rapidly, and large-scale layoffs among state-owned enterprise employees became widespread. However, after China joined the WTO in the early 2000s, the positive effects of trade on the domestic economy precisely offset the economic downturn and job losses caused by the capacity-reduction efforts.

Once again, it is essential to foster new business models and create more job opportunities by advancing strategies such as “mass innovation and mass entrepreneurship” and “Internet Plus.” This will enable us to provide re-employment for workers from traditional industries following capacity reductions. At the same time, by strengthening and expanding the tertiary sector, we can offset the economic downward pressure caused by capacity reductions in the secondary sector.

2. Under the “capacity reduction” policy, A The stock market is focusing on two major categories of investment opportunities.

Supply-side reform will be the main policy theme for 2016, and among its key priorities is the resolution of excess capacity. We need not doubt the government’s determination to reduce overcapacity. Drawing on the experiences of the U.S., Japan, and China in the 1990s—when they undertook capacity reductions in the textile industry—we also have no reason to question the likelihood of success in this endeavor. What truly needs to be considered now is how to seize the corresponding investment opportunities in the A-share market as capacity is being reduced.

2.1. There is no doubt about the policy commitment to capacity reduction.

From the moment decision-makers several months ago identified resolving excess capacity as one of the key battles in supply-side reform, to last week when President Xi Jinping and Premier Li Keqiang both emphasized during their field inspections the need to accelerate the elimination of excess capacity in traditional industries, it seems we can now confidently conclude that decision-makers’ determination to tackle excess capacity has reached a new level. Supply-side reform—especially the resolution of excess capacity—will be the central policy theme for 2016.

Over the past two months, numerous documents, meetings, and speeches by top leaders—large and small—have mentioned the phasing out of outdated production capacity no fewer than ten times. The signals sent by decision-makers are already crystal clear; investors in the A-share market have no reason to doubt the policy commitment to capacity reduction any longer.

2.2. By summarizing successful experiences from both domestic and international efforts in capacity reduction, there is no need to doubt the likelihood of success for this round of capacity reduction either.

(1) Compared to the environment of capacity reduction in China during the 1990s, this time offers greater advantages.

■ The two instances that triggered overcapacity had similar causes:

It is worth noting that the factors triggering the two instances of overcapacity are remarkably similar. In general, an investment boom sparks inflation, after which monetary policy becomes relatively tighter than before. Since economic overheating cannot persist indefinitely, it eventually leads to overcapacity and debt problems.

Specifically, Deng Xiaoping’s Southern Tour speech in 1992 opened people’s minds and sparked a widespread investment boom across the country. In 1993 and 1994, local governments rapidly expanded their investment scales under the slogan “Development is the absolute truth.” As a result, the growth rate of M2 kept accelerating, and the CPI index reached its peak amid overheated investment conditions. Subsequently, as excessive investment expansion cooled down, the CPI dropped sharply, and the growth rate of fixed-asset investment hit a new low—phenomena that gradually gave rise to overcapacity and debt problems.

From the four charts below, we can see that the causes behind the overcapacity in the previous round and the current round are strikingly similar: Credit growth surged rapidly during 2008-2009, and fixed-asset investment growth also accelerated sharply during the same period. At that time, both M2 growth and the CPI reached their peaks. As overheated investment began to cool down and economic growth slowed, various indicators showed a convergence pattern similar to that of the previous round—leading to the problem of overcapacity.

■ What we’ve learned from the capacity-reduction process since 1998:

First, monetary policy. In 1998, in response to the issue of capacity reduction, the government adopted a monetary policy primarily focused on stability. Prior to 1998, the policy was described as “moderately tight”; in 1998, it was adjusted to “appropriate monetary policy”; and in 1999, it became “prudent monetary policy.” Although economic growth slowed somewhat during this period, as shown by the year-on-year chart of outstanding loan balances, credit growth in the years following 1998 significantly declined compared to earlier periods and showed a clear deceleration trend. Similarly, against the backdrop of China’s recent slowdown in economic growth, the monetary policy has been consistently oriented toward stability for several consecutive years. The central bank has employed various tools, including open-market operations, to regulate and stabilize the financial market. As the same chart illustrates, since 2010, the year-on-year trend of outstanding loan balances has been remarkably smooth and stable, indicating that market credit has not been substantially expanded despite the economic downturn.